CHAPTER 11: SAVINGS & INVESTING

Mrs. T. Post

Adapted from Prentice Hall Presentation Software

Saving and Investing• How does investing contribute to the free enterprise system?

• How does the financial system bring together savers and borrowers?

• How do financial intermediaries link savers and borrowers?

• What are the trade-offs between risk and return?

Private Enterprise and Investing• Investment = redirecting resources from being consumed today so that they may

create benefits in the future. – use of assets to earn income or profit.

• When people save or invest their money, their funds become available for businesses to use to expand and grow. – investment promotes economic growth.

A financial system is a system that allows the transfer of money between savers and

borrowers.

The Financial System Financial Assets

• When savers invest, – documents confirming their deposit or bond purchase, such as passbooks or bond

certificates.

• These documents are known as financial assets. – represent claims on property or income of the borrower.

Financial intermediaries are institutions that help channel funds from savers to borrowers.

Banks, Savings and Loan Associations, and Credit UnionsTake in deposits from savers and then lend some of these funds to various businesses

Finance CompaniesMake loans to consumers and small businesses, but charge borrowers higher fees and interest rates to cover possible losses

Mutual FundsPool the savings of many individuals and invest this money in a variety of stocks and bonds

Life Insurance CompaniesProvide financial protection to the family, or other beneficiaries, of the nsured

Pension FundsAre set up by employers to collect deposits and distribute payments to retirees

Financial Intermediaries

Financial intermediaries accept funds from savers and make loans to investors.

Financial Intermediaries

Commercial banksSavings & loan associations

Savings banksMutual savings banks

Credit unions

Financial Institutions that make loans to…

Life insurance companiesMutual funds

Pension fundsFinance companies

InvestorsSavers make deposits to…

The Flow of Savings and Investments

Services Provided by Financial IntermediariesSharing Risk

• Diversification = spreading out of investments to reduce risk.

Providing Information

• Reduces the costs in time and money that lenders and borrowers would pay if they had to search out investment information on their own.

Providing Liquidity

• Allows savers to easily convert their assets into cash.

Return is the money an investor receives above and beyond the sum of money initially invested.

Risk and ReturnReturn and Liquidity

• Savings accounts have greater liquidity, but in general have a lower rate of return.

• Certificates of deposit usually have a greater return but liquidity is reduced.

Return and Risk

• Investing in a friend’s Internet company could double your money, but there is the risk of the company failing.

• In general, the higher potential return of the investment, the greater the risk involved.

Bonds and Other Financial Assets• What are the characteristics of bonds as financial assets?

• What are the different types of bonds?

• What are characteristics of other major financial assets?

• What are the four different types of financial markets?

Bonds as Financial AssetsBonds are basically loans, or IOUs, that represent debt that the government or a corporation must repay to an investor. Bonds have three basic components:

1. The coupon rate — the interest rate that the issuer will pay the bondholder.

2. The maturity — the time when payment to the bondholder is due. Not all bonds are held to maturity. Sometimes bonds are traded or sold and their price may change.

3. The par value — the amount that an investor pays to purchase the bond and that will be repaid to the investor at maturity.

Economists therefore refer to a bond’s yield, which is the annual rate of return on the bond if the bond were held to maturity.

Discounts from Par

Bond purchase without discount from par

=

1. Sharon buys a bond with a par value of $1,000 at 5 percent interest.

2. Interest rates go up to 6 percent.

3. Sharon needs to sell her bond. Nate wants to buy it, but is unwilling to buy a bond at 5 percent interest when the current rate is 6 percent.

4. Sharon offers to discount the bond, taking $40 off the price and selling it for $960.

5. Nate accepts the offer. He now owns a $1,000 bond paying 5 percent interest, which he purchased at a discount from par.

Bond purchase with discount from par

=

Buying Bonds at a Discount• Investors earn interest on the

bonds they buy. They can also earn money by buying bonds at a discount from par.

Bond Ratings

Standard & Poor’s

Highest investment gradeHigh gradeUpper medium gradeMedium gradeLower medium gradeSpeculativeVulnerable to defaultSubordinated to other debt rated CCCSubordinated to CC debtBond in default

AAAAAA

BBBBBB

CCCCCCD

Moody’s

Best qualityHigh qualityUpper medium gradeMedium gradePossesses speculative elementsGenerally not desirablePoor, possibly in defaultHighly speculative, often in defaultIncome bonds not paying incomeInterest and principal payments in default

AaaAaA

BaaBaB

CaaCaCD

Bond Ratings • Standard & Poor’s and Moody’s rate bonds on a number of

factors, including the issuer’s ability to make future payments and to repay the principal when the bond matures.

• A high bond rating usually = sell at a higher price, and that the firm will be able to issue the bond at a lower interest rate.

Advantages and Disadvantages to Bond Issuers• Bonds are desirable from the issuer’s

point of view for two main reasons:1. Once the bond is sold, the coupon

rate for that bond will not go up or down.

2. Unlike stock, bonds are not shares of ownership in a company.

• Bonds also pose two main disadvantages to the issuer:1. Fixed interest payments- even in bad years when

it does not make money. 2. If the issuer does not maintain financial health,

its bonds may be downgraded to a lower bond rating. This makes it harder to sell future bonds unless a discount or higher interest rate is offered.

Types of BondsSavings Bonds• Savings bonds are low-denomination ($50 to $10,000) bonds issued by the United States government. Savings bonds are purchased below par value

(a $100 savings bond costs $50 to buy) and interest is paid only when the bond matures.Treasury Bonds, Bills, and Notes• These investments are issued by the United States Treasury Department. Municipal Bonds• Municipal bonds are issued by state or local governments to finance such improvements as highways, state buildings, libraries, and schools.Corporate Bonds• A corporate bond is a bond that a corporation issues to raise money to expand its business. Junk Bonds• Junk bonds are lower-rated, potentially higher-paying bonds.

Other Types of Financial AssetsCertificates of Deposit

• Certificates of deposit (CDs) are available through banks, which use the funds deposited in CDs for a fixed amount of time.

• CDs have various terms of maturity, allowing investors to plan for future financial needs.

Money Market Mutual Funds

• Money market mutual funds are special types of mutual funds.

• Investors receive higher interest on a money market mutual fund than they would receive from a savings account or a CD. However, assets in money market mutual funds are not FDIC insured.

Financial Asset Markets• One way to classify financial asset markets is according to the length of time for which the funds are lent.

– Capital markets are markets in which money is lent for periods longer than a year. CDs and corporate bonds are traded in capital markets.

– Money markets are markets in which money is lent for periods of less than a year. Short-term CDs and Treasury bills are traded in money markets.

• Markets can also be classified according to whether assets can be resold to other buyers.– Primary markets involve financial assets that cannot be transferred from the original holder, such as savings bonds.– Secondary markets involve financial assets that can be resold, such as stocks.

The Stock Market• What are the benefits and risks of buying stock?

• How are stocks traded?

• How is stock performance measured?

• What were the causes and effects of the Great Crash of 1929?

Buying Stock• Corporations can raise money by issuing stock, which represents ownership in the corporation. A portion of stock is

called a share. Stocks are also called equities.

• Stockowners can earn a profit in two ways:1. Dividends, portions of a corporation’s profits

1. Paid out to stockholders 2. The higher the corporate profit, the higher the dividend.

2. A capital gain is earned when a stockholder sells stock for more than he or she paid for it. 3. If a stockholder that sells stock at a lower price than the purchase price suffers a capital loss.

Stocks may be classified either by whether or not they pay dividends or whether or not the stockholder

has a say in the corporation’s affairs.

Types of StockDividend Differences

• Income stock pays dividends at regular times during the year.

• Growth stock pays few or no dividends. Instead, the issuing company reinvests earnings into its business.

Decision-Making Differences

• Investors who buy common stock = voting owners of the company.

• Preferred stock owners = nonvoting owners of the company– Receive dividends before the owners of

common stock.

Stock Splits and Stock RisksStock Splits

• Division of a single share of stock into more than one share.

• Occur when the price of a stock becomes so high that it discourages potential investors from buying it.

Risks of Buying Stock

• Purchasing stock is risky because the firm selling the stock may encounter economic downturns that force dividends down or reduce the stock’s value. – Riskier investment than bonds!

How Stocks Are Traded• A stockbroker is a person who links buyers and sellers of stock.

• Stockbrokers work for brokerage firms, or businesses that specialize in trading stock.

• Some stock is bought and sold on stock exchanges, or markets for buying and selling stock.

Stock ExchangesThe New York Stock Exchange (NYSE)

• The NYSE is the country’s largest stock exchange. Only stocks for the largest and most established companies are traded on the NYSE.

NASDAQ-AMEX

• NASDAQ-AMEX is an exchange that specializes in high-tech and energy stock.

The OTC Market

• The OTC market (over-the-counter) is an electronic marketplace for stock that is not listed or traded on an organized exchange.

Daytrading

• Daytraders use computer programs to try and predict minute-by-minute price changes in hopes of earning a profit.

Futures and Options• Futures are contracts to buy or sell at a specific date in the future at a price specified today.

• Options are contracts that give investors the option to buy or sell stock and other financial assets. There are two types of options:1. Call options give buyers the option to buy shares of stock at a specified time in the future.2. Put options give buyers the option to sell shares of stock at a specified time in the future.

Measuring Stock PerformanceBull and Bear Markets

• When the stock market rises steadily over time, a bull market exists. (upward trend)

• Conversely, when the stock market falls over a period of time, it’s called a bear market. (downward trend)

Stock Performance Indexes

• The Dow Jones Industrial Average– The Dow is an index that shows how stocks of 30 companies in various industries have changed in value.

• The S & P 500– The S & P 500 is an index that tracks the performance of 500 different stocks.

The collapse of the stock market in 1929 is called the Great Crash.

The Great CrashCauses of the Crash

• Many ordinary Americans were struggling financially:– many purchased new consumer goods by

borrowing money

• Speculation, or the practice of making high-risk investments with borrowed money in hopes of getting a big return, was common.

Effects of the Great Crash

• A much wider, long-term crisis — the Great Depression during which many people lost their jobs, homes, and farms.

• Americans also became wary of buying stock.

• By early 1980s, only about 25 percent of households in the United States owned stock.